Crunch time on interest rates

I have a business proposition for you: how would you like to invest in a company with a steady stream of incoming business, customers that are unlikely to switch to competitors and where, if it all goes wrong, the government guarantees it won't fail?

''Where do I sign?!'' I hear you ask.

In defending their attempts to pass higher funding costs on to borrowers, the banks have come up with a sneaky new line of defence. ''Oh, yeah, sure we earn multibillion-dollar profits'' - $25 billion a year for the big four, to be exact - ''but you've got to look at that compared to our size, you've got to look at our return on equity.'' At which point the listener, bamboozled by jargon, usually slinks away in dismay.

"If a business can pass on higher costs entirely to customers, it is a clear sign there is a failure of competition in the market."

So let's have a look. Do the banks deliver an excessive return on equity?

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The phrase ''return on equity'' just means a company's profit expressed as a percentage of total shareholder equity invested.

Data from market analysts Morningstar showing the results of the top ASX 200 companies for the past financial year shows bank shareholders enjoyed a return on their equity of 15.2 per cent.

The banks insist this is in line with the return on equity of banks in countries such as Canada. But information is scant. So how does it compare to other companies in Australia? Answer: pretty favourably. The lower end of the spectrum is dominated by low-risk, blue chip companies, such as utilities, which as a group delivered a return on equity of about 7 per cent. Makers of capital goods, like paper and toilet furnishings, returned about 4 per cent. Energy producers, like oil, coal and gas, returned 7 per cent and transport companies about 5 per cent.

At the upper end of the scale were mining companies, including BHP Billiton, which returned on average about 29 per cent, pharmaceutical and bio-tech companies on 25 per cent, and retailers on 29 per cent.

Now, consider the offer I made in my opening par: what sort of return would I need to promise to tempt you to invest in such an attractive proposition? Very high, or very low?

Presumably, presented with such a good bet, plenty of investors would be interested and I'd have to offer only a small return. If it were a riskier bet, there may be less interest and I'd have to offer a higher return.

Economists call it the risk-return trade-off: the higher the risk, the higher the return.

High returns on equity tend to be reserved for companies undergoing a cyclical boost such as mining (BHP Billiton had a return on equity of 38 per cent and Fortescue Metal Group 75 per cent), embody a high degree of human capital or intellectual property (like the websites Seek at 31 per cent or carsales.com on 54 per cent) or producers of patented goods (Cochlear, 5 per cent).

Banking, by contrast, ain't exactly rocket science. It's a very simple process of buying low and selling high. Borrowing at a certain rate, lending at something higher and sitting back to collect the interest. The potential for innovation is low, on par with, say, a utility. Banks are a low-risk investment. Why, then, should they offer shareholders average or above rates of return? They shouldn't.

But look at the numbers: the return on equity of Commonwealth Bank last financial year was 18.5 per cent, followed by ANZ on 15.2 per cent, Westpac on 15.1 per cent and NAB on 13.1 per cent.

So how do the big banks get away with it? When faced with higher costs, businesses in a competitive market have only three options: cut costs, raise prices or accept lower profits. Most businesses have only a limited capacity to raise prices - because they would be undercut by a competitor. If a business can pass on higher costs entirely to customers, it is a clear sign that there is a failure of competition in the market. Which, of course, is the bottom line with the Australian banking system. Has been for a long time.

Things improved in the 1990s, when the arrival of foreign banks and non-bank mortgage orginators such as RAMS and Wizard forced banks to offer lower rates to customers.

But the global financial crisis killed all that. The big four once again dominate the market, having swallowed several competitors, including St George and BankWest.

Customers have every right to feel ripped off if they're slugged with higher rates. Australian banks just don't take enough risks or add enough value to justify their high rates of return.

44 comments

The argument that businesses need to maintain a certain return on investor's equity is dodgy to start with,

When the Commonwealth Bank was privatised 20 years ago, the selling price was somewhere between 7 and 8 dollars a share yet within a few years was 4 - 5 times that price. Which investors required the massive return - the ones who took the risk in 1991, or those who bought in for good profits a few years later?

Commenter

Ross

Location

MALLABULA

Date and time

February 10, 2012, 8:21AM

Ross, return on equity has nothing to do with the share price. It is the money that is made (profit) relevant to the amount invested. In the case of the Banks this is actually reasonably poor. Those who did buy shares at the initial float benefited from payment of dividends etc.

Commenter

Michael

Location

Sydney

Date and time

February 10, 2012, 9:25AM

Thanks Michael - but how is the amount invested calculated?

Jessica states that it is the return on the total shareholder equity investigated. Is the total shareholder equity different in some way to the share price x share number?

Commenter

Ross

Location

MALLABULA

Date and time

February 10, 2012, 12:02PM

Ross, the return on equity is net profit divided by the average of the beginning and ending shareholders equity. You can get this figure by looking at the balance sheet but essentially it is calculated by taking all the assets for a particular period and subtracting all the liabilities. It is essentially made up of contributed capital and retained earnings (profits not paid out as dividends). It has nothing to do with the share price or return you might get from buying shares at Y and selling at X.

Commenter

Andrew

Location

Sydney

Date and time

February 10, 2012, 3:41PM

Ever since Christ entered the temple and drove moneylenders thence, flogging banks has been a required activity for journalists and an acceptable if predictable one for the rest of us.

Borrowing short and lending long is actually inherently risky. At various points in history - as BankWest and St George discovered - it's simply too hard to refinance your lending at economic rates. So you get swallowed by one of the few that can.

The reason that RAMS and Wizard have departed, and that Aussie cowers beneath the skirts of CBA, is that money is simply not available cheaply anough in sufficient quantities to make those cut-price models work.

Commenter

Gold Standard

Location

Sydney

Date and time

February 10, 2012, 8:28AM

None of which takes away from the argument presented in the article, that banking is indeed quite profitable compared to other "blue-chip" investments, AND that the business is guaranteed never to fail.

What you call "economic" rates I would imagine be those that hark back to the golden days of easy credit when the banks were raking it in. Now that times are tough, rather than being prepared to make a lower profit (as most other industries are) banks can maintain the same level of profit, as the article says. by eliminating the competition so they can raise their prices.

You can bleat all you like about journalistic bank-bashing, but nothing you say refutes the arguments made.

Commenter

george

Date and time

February 10, 2012, 8:59AM

"Borrowing short and lending long is actually inherently risky"

Unless of course you are a big bank in which case the government will step in and guarantee the safety of your money because failure is untenable.

Commenter

Goresh

Location

Brisbane

Date and time

February 10, 2012, 10:03AM

Leaving the 'Jesus' part of your response aside, a quick search of the web finds that Wizard and RAMS are still around. Sure, they've been acquired by larger entities but your statement that they've departed is merely an attempt to exaggerate a description to affect an emotional response and give greater weight to your case.Your description of banking activities as simply 'borrowing short and lending long' is either another exaggeration or you've simply read the first paragraph of a longer article and haven't been bothered to finish it.

Commenter

The Badger

Location

Newcastle

Date and time

February 10, 2012, 10:22AM

Rams Wizard and Aussie home loans all relied on the securitisation market for their funding. One of the first impacts of the GFC was that the funding for this lending was the first to dry up. They were them caught as they had to refinance their loan books which is why the major banks have since assumed their operations. So while it may appear that they are still in operation they are now only subsidiaries of the major banks. This exercise showed that funding raised from the secondary markets are risky.

Commenter

Michael

Location

Sydney

Date and time

February 10, 2012, 10:40AM

And banks don't simply obtain all of their funding from the secondary market, they use less risky sources.